Can lightning strike twice?

Perhaps more than ever analysis of Japan’s Liquidity Trap carries greatest consequence, as most Western developed nations are in the grip of the “2008 Financial Crisis”, which is a downturn which is a result of a property and asset price boom similar to Japan’s Assets bubble.

So what actions have the U.S government and the Fed taken; one of the first steps was to bail out those firm’s which were deemed “too-big-to-fail” through the Troubled Asset Relief Program (TARP) set up in October 2008, and the since late 2008 the three month Treasury Bill rates have been set to values of 0.04% and less and have also rarely peaked above values of 0.20%. The Fed also engaged on its most aggressive monetary expansion through quantitative easing since the 1930s “Great Depression”.

So far as we can tell to date, the actions taken in by the Fed and US government appear to be managing the downturn: with GDP Growth rates and inflation shown below and Inflation rates for the U.S;

After a sharp but brief slump in 2009 the Gross Domestic Product began to grow again in 2010, similarly after a deflationary period in 2009 inflation has being growing steadily in a controlled manner consistent with successful inflation targeting as a result of effective monetary policy.

While there are lots of similarities between the recessions experienced by the U.S and Japan in the 2000s and 1990s respectively, so far the U.S has not got caught in a liquidity trap. So what might be the difference? One major factor is the U.S demography, were the labour force is buoyed by immigration mainly from Latin American, and a historical tendency not to save among its population.

Does this reinforce theories suggested by Paul Krugman or is there some difference in the nature of the boom’s that causing different features in the bust?

(Here it comes) The Austrian view;

Opposition to Keynes original description of the liquidity trap outlined in ”The General Theory” is well voiced, none more-so, than the Beranek and Timberlake 1987 critique. Empirical analysis looking at changes in sensitivity of money demand; comparing the Great depression (U.S 1930s); when interest rates were held at low values for prolonged periods of time compared to other periods, found there was no sensitivity increase when interest rates fell. In essence this suggests that no examples of the Liquidity Trap yet existed and that in conditions similar to those that Keynesian theory require for a liquidity trap to occur, the probability of a trap actually occurring was low.

There is less opposition to more modern descriptions of the Liquidity trap proposed by Paul Krugman in the late 1990s and his interpretation of Japan’s economic slump. His explanation is now widely accepted and held in regard by key Policy makers in Central banks around the globe, including the current chairman of the American Federal reserve Ben Bernanke.

However those of the Austrian school of thought have not remained silent on Japan’s slump, and of course offer their pragmatic no-thrills explanation. As Christopher Mayer (2004) explains Japan’s lost decade is simply part of the classic business cycle, but attributes actions taken by the Bank of Japan to its unique prolonged stagnation.

Mayer suggests that following the 1985 “Plaza Accord” the Bank of Japan was wrong to protect its exports by depreciating the Yen through increases in the money supply and cutting its discount rate by half. This resulted in economic “conflagration”, (the asset price bubble) as the creation of money and credit is not support by underlying capital. This inevitably leads to a bust, and the economy cannot correct itself until businesses and investment projects that were sustained by false capital are liquidated and resources and capital are directed to projects with greater profitability.

It follows then that Mayer continues to criticise interventions by the Japanese government and Bank of Japan to save those firms that were “too-big-to-fail”, and continue to try spend their way out of trouble though quantitative easing. Mayer cites such policies as stopping the market form “self-correcting” thus there is a prolonged period of stagnation.

This is widely considered an extreme view, and an argument that cannot easily be proven empirically but perhaps only be accepted by a change in philosophy.

Attack the Future to Change the Present!

So the goal is set for Japan’s government and its intermediary the Bank of Japan to increase the demand for money and lower its populations propensity to save in spite of the near zero nominal interest rate. To achieve this target it they must influence future expected prices, by changes in either fiscal or monetary policy.

There are many ways in which the Bank of Japan can achieve this in theory, unfortunately they are mostly still only theory as to implement most methods would require unfathomable quantities; often multiples of GDP for monetary policies in repeated instalments and politically unpopular fiscal policies. It is fitting that to break free of a situation once regarded as possible freak occurrence at an implausible boundary condition of economic theory, requires a solution as seemingly implausible and unbounded.

In a paper in 2000, aptly named “Japanese Monetary Policy: A Case of Self-Induced Paralysis” the irrepressible Ben Bernanke outlines some of the plausible “implausible” options open to the Bank of Japan in the effort to escape the liquidity trap that include;

*An extended period of 0% nominal interest rates, with inflation targeting.

*Substantial unilateral depreciation of the Yen leading to price-import inflation.

*The “helicopter drop” approach to quantitative easing, which is essentially to keep printing money until the price level rises, or if it fails to raise the price level, then the real wealth of the population will grow without bound, and at some point the public must transfer cash to goods increasing demand.

*Unconventional Open Market Operations; the Bank of Japan should go beyond purchasing just government and corporate bonds, by purchasing non-performing bank loans at face value this would effectively amount to a fiscal policy of gifts to the private sector to stimulate aggregate demand. Or invest heavily in foreign assets and testing the nerve of the market, either inflation will materialise or the Bank of Japan will become the richest institution in the world as the price of assets it is acquiring will increase without bound.

Many of the ideas outlined by Bernanke where originally conceived or hinted upon by Paul Krugman in 1999, but Bernanke is accredited with presenting the Bank of Japan with the all-important required ingredient of “Rooseveltian Resolve”. Which refers to the former president of the U.S; Franklin D. Roosevelt elected during the “Great Depression” in the 1930s.

Fighting Against the Tide.

Looking back at Japan’s lost decade (1990s) which has now been identified as a real life interpretation of a liquidity trap; which theoretically could last indefinitely,( and in fact has since been redefined as Japan’s lost decades (1990s & 2000s)) we can see growth has rarely topped 2% by year on year change in GDP seen below;

Inflation; which is no longer in the full control of the Japanese Government has seemingly reflected changes in growth (shown below). This can be related to evidence put forward by Paul Krugman (1998) that prices in a liquidity trap are not affected by money supply but more so by demand that is driven by future expected prices. Future prices as I alluded to previously are dependent on people’s perceived future growth, which will likely represent some smoothed lagged function of current growth at any given time. As the populations perceived future growth is based loosely on current growth and will dictate where people spend or save.

The premise of the theories set before are most evident in 2007 as the largest increase in inflation occurs at the height of the U.S and Europe property bubble just prior to the “Financial Crisis of 2008”. We also note continued bouts of deflation from 1999 to 2010 that are consistent with lows in economic growth.

So the question is now how change the Japanese government and its central bank (Bank of Japan) exert the most influence future expected prices, in the hope of lick-starting an increase in demand for money?

So What Made the Theory Stick?

In the 1990s following the collapse of Japan’s asset bubble, the country was in the grip of a recession. Growth as measured by GDP was less than a modest 2%, reinvestment by Japanese corporates was effectively nil, and there was strong competition emerging from neighbouring nations such as Malaysia and Thailand. The Bank of Japan needed to take action so it lowered the nominal interest rate and embarked on quantitative easing increasing the money supply, yet there was no sign of growth on the horizon.

Japan had found itself in a liquidity trap; an idea that is was previously regarded only as a theoretical boundary condition. Money is added to the economy and with a low or nearly zero nominal interest rate there is no increase in borrowing or investment, instead money is saved despite lower prospect of returns. The government’s fiscal policy is impotent and growth remains stagnant. So where has this mentality of such tentativeness towards investment and preference to save come from?

If we first consider the supply side to the monetary base; there is nothing unique in the way Japan implements its monetary policy. Thus it is expected that even in a recession, when additional funds are supplied to the monetary base through the central bank (Bank of Japan) via open market operations that inflation rates should increase. One potential sticking point may have been Japan’s financial sector that was widely viewed as highly inefficient and over regulated, resulting in lack of credit. This argument unfortunately doesn’t carry much weight, as the regulatory restrictions were similar to the time during the boom when credit was easily accessible.

So we must consider the demand side; if it is the case that in a recession peoples’ expected future income may be lower than compared with amounts needed to satisfy current consumption patterns, people will prefer to save resulting in little or no change in inflation rates. Some fairly unique characteristics of the Japan’s demography could explain such low expectations of growth and expected future wealth; Japan’s ageing population combined with low immigration has resulted in a declining labour force, which may be a factor in the negative expectation of future economic capacity.

While it is accepted that Japan’s demography does figure highly in the argument as to problem faced by Japan in the 1990s it is not a fool-proof explanation, and other arguments do exist. Many of which are based on inefficient microeconomic systems, but perhaps a wavy macroeconomic problem requires a wavy macroeconomic explanation.

When a Big Enough Bubble Bursts, it’s Gonna Make a Splash.

Commonly known as the “Lost Decade” the period from 1991 to 2000 following Japan’s Asset Price Bubble, Japan experienced a prolonged period of economic stagnation. It is during this time period that great Keynesian advocate Paul Krugman (1998), claims Japan fell into its liquidity trap. While it is historically well known that cyclic nature of any economy predicts a low after every high, one wonders what type of boom doesn’t just go bust?

Japan’s Bubble was the accumulation of a number of factors including; domestic policy encouraging widespread saving of income, Japan's historical large trade surpluses, financial deregulation and a strengthening Yen. Which was compounded by the Plaza Agreement of 1985 by the world’s leading economies to weaken the U.S dollar relative to the Yen and German Deutsche Mark.

The full effects of the above factors came to fruition in the period 1986 to 1991, when real estate and stock prices in Japan were greatly inflated, fuelled by easy access to credit and aggressive speculation. At the peak of the boom select properties in Tokyo were worth up to $93,000/FtSquared and in December of the same year the Nikkei stock index closed as high as 38915.87. These benchmarks represented a three-fold increase in property prices in less than a decade and similar magnitude of increase in stock prices.

The inevitable happened in 1990, boom went to bust helped along by the Bank of Japan raising interest rates. A customary banking crisis enveloped prompting Japanese government to announce a taxpayer backed guarantee on bank deposits, which effectively amounted to a bailout on firms that were considered “too big to fail”. There were also a number of economic stimulus projects leading to budget deficit in less than four years. In 1991 property values were only 40% of the peak value attained less than two years previous.

The reaction of population was to stem consumption and increase savings. Firms used earnings in an attempt to reduce capital structure and reinvestment fell. A recession gripped the economy and the Japanese government lowered interest rates close to zero and engaged in an expansive policy of quantitative easing with the goal of creating growth.

In spite of the Japanese government extensive efforts through monetary changes in supply, the economic stagnation continued throughout the whole of the 1990s. In essence Japan’s economy had fallen prey to the Keynesian prediction outlined for the zero bound condition on interest rates.

What is this “Liquidity Trap”?

The Liquidity Trap is an idea that originates as an extreme case scenario in Keynesian monetary theory which became reality in Japan in the 1990s, as an isolated phenomenon in modern international economics.

Keynesian theory outlines that money supply influences prices and economic output through the nominal interest rate. This then suggests that increasing money supply reduces the interest rate through a money-demand equation, which will in turn stimulate economic output and consumption. The short-term nominal interest rate cannot be negative, otherwise there is a “free-lunch” for borrowers i.e. if lenders give x amount and expect less than x in return, borrowers will have made a no risk profit.  So there must therefore be a “zero bound” on the short-term nominal interest rate.

Keynes inferred that once money supply has been increased to some level where the short-term interest rate is zero; there will be no further influence on economic output or prices by increasing money supply. This scenario is known as the “Liquidity Trap”.

Or more elegantly described by John Hicks (1937) as, that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes.

Modern descriptions of the Liquidity Trap centre on an intertemporal stochastic general equilibrium model, where aggregate demand depends on current and expected future interest rates. The equilibrium trap still occurs when the short-term nominal interest rates are sufficiently close to the zero bound, and central bank is unable to compensate for large deflationary shocks through monetary policy. It’s still the same cake with more trimmings, but just as hard to swallow.